Whoosh! That’s the sound of up to $5,000bn worth of collateral draining from the financial system. And it is not a reassuring one.
“Collateral is the grease that oils the lending system,” says Richard Comotto of the International Capital Market Association. “If the grease starts to freeze or run out, the loan cogs won’t run as well.”
Large banks typically reuse securities handed over to them by big investors such as hedge funds, insurers or pension funds. They do so by pledging the assets out through the so-called repo or securities lending markets, generating a return for themselves and their clients but, in the process, also helping to lubricate the global financial system.
Since the financial crisis, though, these “chains of collateral” have become much shorter, meaning securities including government or mortgage bonds are not being recycled through the system as much as they used to be.
While that might help reduce overall risk, by limiting leverage, it has important implications for the way the system works and the global economy.
Some analysts believe that this fall in collateral use could actually serve to increase “hidden” risk in the financial system as the market devises new ways of tackling the shortage.
Manmohan Singh, an IMF economist, says in a new working paper that there has been “a significant decline in the source of collateral”.
“Since collateral can be reused, the overall effect may have been a $4,000bn-$5,000bn reduction in collateral,” he says. That takes the estimated amount of collateral flowing through the system to about $5,800bn at the end of 2010, far below its 2007 peak of $10,000bn.
According to Mr Singh, the number of times a security is passed around the system has fallen from an average of three times before Lehman’s 2008 collapse to 2.4 times at the end of 2010.
“Intuitively, this means that collateral from a primary source takes ‘fewer steps’ to reach the ultimate client,” he writes in the paper.
One reason collateral use has fallen is that market participants are more vigilant about the creditworthiness of counterparties and how business partners might use collateral sent to them.
“Everybody is less trusting about the use of collateral,” says Fred Ponzo, founder of GreySpark Partners, a capital markets advisory business.
Financial institutions are also increasingly trying to manage risk by taking “haircuts” – clipping some of the value on assets being traded to add a bigger safety cushion.
That, in turn, limits the extent to which securities can be recycled just as the pool of available collateral is shrinking.
“There’s less and less high quality collateral and more and more demand [for collateral],” says Mr Commotto, who adds that even government bonds are being questioned as collateral as a result of the sovereign debt crisis in Europe.
More collateral is also being tied up at the world’s central banks, and especially at the European Central Bank, as commercial lenders turn to them for financing.
The ECB’s balance sheet has ballooned to more than €2,000bn as the region’s banks exchange their assets, such as bank bonds or bundled loans, in return for central bank funding.
The lack of financial lubricant has important consequences.
It may, for example, be one reason why businesses and households have not felt the full effect of monetary easing by central banks, analysts say. Financial lubricant is needed to transmit rate cuts and boost the economy.
“You’ve got a massive disruption of liquidity,” says Marc Ostwald, government bond specialist at Monument Securities. “The transmission mechanism for monetary policy breaks down if trust perceptions” disintegrate, he says.
Regulatory reforms, including new capital rule for banks and moves towards central clearing of derivatives trading, are expected to intensify the chase for “decent” securities, potentially clogging the system further by locking up more collateral.
One result of all this has been a boom in specialist collateral management services. So-called “collateral transformation” is being marketed to derivatives users as a way for them to obtain the cash or government bonds they will need for central clearing.
Liquidity swaps, where banks exchange illiquid assets for more liquid ones, are also being used by banks to help meet the new requirements on capital.
These kinds of services may help to keep the world’s financial plumbing in good running order. However, many market participants still expect demand for collateral to exceed supply.
Moreover, some argue that such services place a question mark over whether risk is being reduced or simply shifted around the system, potentially flowing into less regulated areas as it did before the 2008-09 crisis.
The concern over such flows is that the effect, should there be another bout of severe market turmoil, could be similar to the rise of the “shadow banking system”, which thrived on leverage in the run-up to the financial crisis and helped cause the huge losses at Lehman and others.
The decline in collateral “may entail some difficult choices for the markets and regulators”, says Mr Singh.
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